Repay or Invest ?

Should savers prioritise debt repayment or fresh investments?

There's a typical question about an investment problem discussed frequently.

 One particular person has a housing loan on which he is paying interest at the rate of 10.50 per cent per annum. He's paying this monthly EMI comfortably out of his income without any problems. Now, he finds that he also has some cash accumulated which he can invest.

He would like to know which is the better option: should he repay some of his housing loan before schedule, or should he invest in an equity mutual fund for the long-term.

This is not an uncommon dilemma. In fact, one would guess that practically every salary earner who takes a housing loan faces it at some point. You take a loan at an EMI you can afford. Eventually, your income increases and now you find that can pay back more of the loan than you'd originally planned. If you were to ask this question of a financial planner, the chances are that he would tell you to repay the loan first.

That advice is based on what is almost a first principle of personal financial planning--clear your debts before you save. That principle is a sound one and should almost always be followed.

It is  'almost' always.

If the choice were between clearing expensive credit card debt and saving, then clearly, one should do that. The same probably holds for most consumer loans, including big ticket ones. And certainly, this principle is most relevant to people who try to borrow and invest.

However, there are some caveats to the standard advice. Long-term investments in an equity mutual fund with good track record can fetch higher returns than the interest that this saver is paying on his housing loan. SIP returns are high for long term periods.

This situation is true for everyone who is trying to save while holding a housing loan.

In fact, in the case of a housing loan, the effective trade-off is even more in favour of not repaying the loan early because of the tax breaks one gets on the interest paid.

Here is how the savings option can work out:

Invest 10%  of your Home Loan's EMI in an Equity mutual fund SIP, with good track record - ( Systematic Investment Plan, monthly installments).

All your home loan - principal and interest- can be  recovered with an additional profit  in 20 years.

Example:

Consider  a Home Loan of Rs.20 Lac for 20 Years with an annual interest rate of 10.50%.

EMI will be Rs. 19,968.

In 20 Years,  Rs. 47,92,930  is to be repaid.

(Interest: Rs.27,92,930;Principal: Rs.20 Lac.)

Simultaneously, along with the EMI payments,start an SIP for Rs  2000 ( 10 % of the EMI) for 20 Years in an equity mutual fund with good track record.

With 20.40% returns, Fund Value will be 67,18,375 after 20 years.

Thus you get back all your EMI payments  along with a  profit of Rs. 19,25,445.

The calculations are based on actual figures as per past records.

The facts :

1.SENSEX has given an average return 20.4% in the past 36 years from 1979 to 2015

2.UTI MNC Fund has given a CAGR (compounded annual growth rate) of 21.13 % in the past 15 years.

3.UTI Equity Fund has given a CAGR  of 24.90 % in the past 4 years.

4.UTI Midcap Fund has given a CAGR  of 32.07 % in the past 5 years.

What is yield?

What exactly is  yield and how does it differ from coupon rate?

The term yield is used to describe the return on your investment as a percentage of your original investment.

Yield in the case of stocks

Yield is the ratio of annual dividends divided by the share price. If a stock can be expected to pay out Rs 1 as dividend over the next year and is currently trading at Rs 50, its dividend yield is 2%. Or, if the stock price drops to Rs 25, its dividend yield rises to 4%.

The yield can be calculated based on dividends paid over the past year or dividend expectations for the next.

Yield in the case of bonds

In the case of a bond, the yield refers to the annual return on an investment. The yield on a bond is based on both the purchase price of the bond and the interest promised – also known as the coupon payment.

Although a bond’s coupon rate is usually fixed, its price fluctuates continuously in response to changes in interest rates in the economy, demand for the instrument, time to maturity, and credit quality of that particular bond.

As a result, after bonds are issued, they trade at premiums or discounts to their face values until they mature and return to full face value.

Let’s say a bond’s face value is Rs 1,000 on which an investor can earn 5%. This means that the coupon is 5% and an investor who buys the bond and holds it till maturity will get Rs 50 every year over the tenure of the bond.

Now the price of the bond drops in the market to Rs 980. That means the current yield is Rs 50 divided by Rs 980 = 5.10%.

Later, the price of the bond rises to Rs 1,030. That means the current yield is Rs 50 divided by Rs 1,030 = 4.85%.

As the price of the bond fell, its yield increased.

Because yield is a function of price, changes in price result in bond yields moving in the opposite direction. There are two ways of looking at bond yields - current yield and yield to maturity.

Current Yield

This is  the annual return earned on the price paid for a bond. It is calculated by dividing the bond's coupon rate by its purchase price.

For example, let’s say a bond has a coupon rate of 6% on a face value of Rs 1,000. The interest earned would be Rs 60 in a year. That would produce a current yield of 6% (Rs 60/Rs 1,000).

When a bond is purchased at face value, the current yield is the same as the coupon rate. But let’s say the bond was purchased at a discount to face value – Rs 900. The current yield would be 6.6% (Rs 60/ Rs 900).

Yield to Maturity

This reflects the total return an investor receives by holding the bond until it matures. A bond’s yield to maturity, or YTM, reflects all of the interest payments from the time of purchase until maturity, including interest earned on interest.

The formula for calculating YTM is as follows.
 

Let's work it out with an example: Par value (face value) = Rs 1,000 / Current market price = Rs 920 / Coupon rate = 10%, which means an annual coupon of Rs 100 / Time to maturity = 10 years.

Taking the above example and using the formula, the YTM would be calculated as follows:

YTM = Rs 100 + [(Rs 1,000-Rs 920)/10] / (Rs 1,000+Rs 920)/2

After solving the above equation, the YTM would be 11.25%.

Understand the Emotion in Your Financial Decisions

In a perfect investing world, we’d all respond like robots. The markets go up, we’d know it’s time to sell. The markets go down, we wouldn’t have any problem buying.

But because we aren’t walking, talking algorithms, we’ll almost always need to take emotion into account. We’ll almost always need to weigh financial decisions by both the numbers and how we feel.

Seeing the emotion in our investing decisions may seem like a small thing. Learning to understand it though is huge for future goals.

For instance, think about the reasons you own the investments you own. I suspect more than a few of you have at least one investment, maybe more, that makes no sense. Unless you consider your emotional attachment to that investment.

Maybe it’s stock from an old employer. Maybe you bought Apple because you really love your iPhone. Whatever the investment you bought, you’re probably holding on to it for emotional reasons.

When you step back, you have a really hard time identifying how this individual investment fits into your bigger plan. But you can’t bring yourself to let it go — at least not yet.

We also need to understand how emotion can stop us from making smart decisions. We need to be aware that liking an investment a lot may not be enough to justify owning it. On top of that awareness, we need to remember how our strong emotions may lead us to make a mistake.

Pause for a minute and think through a big financial decision you made based mostly on emotion. Maybe it turned out great, but for sure you made more mistakes than you expected.

Think it through in two steps. Weigh how you feel about an investing or financial decision. Then, ask someone you trust, with no direct connection to the outcome, what they think.

If the person you trust suggests the opposite of what you want to do, take a deep breath and work through the reasons why. You may still end up doing exactly what you planned to do. But having this check-and-balance in place can help you see potential issues.

You are most definitely not a robot. That said, there’s no reason for emotion to stop us from making good financial decisions.

Boost in overseas fund expected as NRI investments will now be considered domestic

Aiming to attract overseas funds, Indian government has decided that non-repatriable investments by NRIs, OCIs and PIOs will be treated as domestic investments and will not be subject to foreign direct investment caps. The Union Cabinet, chaired by Prime Minister Narendra Modi, had approved amendments, including changes in definition of NRIs, to be incorporated in the FDI policy.

Investments by NRIs under under Schedule 4 of FEMA regulations will be deemed to be domestic investment at par with the investment made by residents, an official statement said. The Cabinet’s decision is expected to result in increased investments across sectors and greater inflow of foreign exchange remittance leading to economic growth of the country, it added.
The government had earlier raised the FDI limit in sectors such as defence, insurance, real estate, railways and medical devices. During his foreign vists, Prime Minister Narendra Modi has been reaching out to NRIs to invest in India. Non-resident Indians too have been demanding that their investment be considered as domestic investment.
A committee, set up to look into the possibility of treating non-repatriable NRI funds as domestic investment, had earlier said that NRIs might prefer investing through corporate entities.
Facility of investment on non-repatriable basis was introduced primarily with the intention of providing NRIs an investment option for utilisation of their domestic resources, which were not freely repatriable. It was intended to provide NRIs an incentive to bring funds into India without repatriation rights, at a time when foreign exchange reserves were limited and capital inflows were modest, the statement said.
According to PTI, the provision should continue to incentivise investments by NRIs, including OCIs and PIOs, resulting in increased investments in the country. Since the investment made under Schedule 4 are on non-repatriable basis, it needs to be clearly provided that such investments, for the purposes of FDI policy, are domestic investments, it added.
“This will enable investments by NRIs, OCI cardholders and PIO cardholders under Schedule 4 on non-repatriation basis, across sectors without being subjected to any of the conditions associated to foreign investment,” it said.
During the April-February period of the previous fiscal, FDI rose by 39 per cent to USD 28.81 billion as against USD 20.76 billion in the same period last fiscal.

Are we equipped to deal with an unexpected calamity?

A calamity can come in any form – earthquake, hurricane, flood or fire. The recent Nepal earthquake left many homeless and resulted in a huge loss of property. It is only after a disaster strikes that we think about the loss.

How we can prepare  in advance to protect ourselves and our  loved ones from any calamity ?

Emergency fund

One must have an emergency fund equivalent of six months of our normal household expenses to tide over any contingency arising from the calamity such as hospitalization, loss of business.

Documents

Make sure that we have easy access to important documents like insurance policies, driving licenses, identity card, birth/death certificate and even bank account numbers if they have to vacate their house immediately. It is advisable to keep such documents at a place where they can be easily located. We can also keep such documents in bank lockers.

Get insured

People must first do insurance audit, which means calculating how much insurance is needed to protect their family from any tragedy.

If you already have earthquake or fire insurance, it is best to review it once. Finding out the latest value of the property and belongings will help you estimate the quantum of insurance required.

Life and accidental insurance policies

A calamity can claim people’s lives or can leave them disabled. Getting insured removes the financial burden from the people to a large extent when they are affected by any tragedy or in case of any emergency. They must buy four policies - term policy, health insurance, personal accident policy and critical illness policy. 

Home insurance

One of the biggest losses which occur in a calamity is the loss of a property. For Indians, home is associated with the sentiments of the people. Therefore, buying cover for fire insurance or any cover against earthquake is necessary.

Maintain records

It is advisable to keep a record of all belongings which will help us settle insurance claims fast. 

When time comes to settle a homeowner’s insurance claims, it helps to have a thorough record of your home’s contents. There are two ways to maintain your inventory - using photography or videotape and maintaining a written list. Of course, if you want to be thorough, you can do both.

Taking photos of your possessions or videotaping them is the easier of the two methods. If you choose to videotape, use the soundtrack to describe each of the items. Be sure to include shots of your cars, the contents of your garage, closets, drawers and basement as well as of the outside of your home. The photos, negatives, tape or computer disk should be stored in your safe-deposit box or emergency kit. 

The more difficult method is to make a list of your possessions, including brand names, model and serial numbers, and purchase prices and dates to make it easier to estimate their values for insurance or tax purposes. You may find it easier to keep your list organized by room. Computer software is available to help organize the job. Some items, such as jewelry and collectibles, may require a professional appraisal. Your insurance representative can help you determine which items to have appraised. Again, the physical list or computer disk and copies of any appraisals should be kept in your safe-deposit box or emergency kit. 

Think of  examples

Generally, we are not inclined to buy insurance unless a tragedy strikes. To educate a child, we give examples to make them understand better. Similarly, people are to be enlightened with examples .